While EU policymakers make arrangements for their 14th summit in the last two years, Europe’s flagging economy continues to slip deeper into recession. On Monday, the Eurozone’s Manufacturing Purchasing Managers’ Index (PMI) reported that production and new orders had declined for a 5th straight month. According to a survey of economists by Reuters, “The euro zone economy is already stuck in a recession that will last until the second quarter of 2012….They forecast the economy will probably see no growth this year.” (Reuters)

The slowdown in manufacturing is just the latest sign that political gridlock is taking its toll on the broader economy. While politicians wrangle over the details of a proposed “fiscal union”, unemployment continues to rise and stagnation sets in across the continent. Insane adherence to budget-shrinking austerity measures have made a bad situation far worse. Instead of expansionist “counter-cyclical” policies, EU leaders have forced debt-stricken countries in the south to undergo internal devaluation and endless rounds of debt deflation to meet their budget targets. The belt-tightening has shrunk government revenues, increased the deficits and ignited widespread social unrest.

The deteriorating economic situation is further complicated by funding stresses in the banking system that foreshadow a severe credit crunch in the near future. EU banks are no longer able to fund themselves in the wholesale market and must depend almost entirely on the European Central Bank (ECB). New ECB president Mario Draghi has tried to prop up the faltering system by offering “limitless” 3-year loans at 1 percent on all types of collateral. In its first tender, the ECB issued 489 billion euros (nearly $600 billion) to EZ banks, but the banks immediately deposited 452 billion euros of that sum back at the ECB. The condition of the banks is considerably worse than anyone had imagined. They’re hoarding money to meet new capital requirements and in order to roll over their debts now that they’ve been locked out of the markets. Here’s the story from Reuters:

“Euro zone banks will continue to park their cash with the ECB in 2012 rather than lend it as recent cash injections offer little hope of thawing frozen interbank markets….

Banks are waiting for the new year before deciding what to do with the money, but analysts say they are unlikely to lend to other banks or to the real economy as long as the sovereign crisis shows no sign of abating.

They will instead use the money to pay back their debt as bond markets have all but dried up for them. They also have to cover holes left by retail clients moving their savings out of the sector due to fears that sovereigns may take private lenders down with them if the crisis intensifies.

Against that backdrop, the ECB will probably keep flooding the system with liquidity — it plans another three-year auction in February — with any funds in excess of the banks’ funding needs likely to end up back with the ECB for rainy days.” (“MONEY MARKETS-Banks to keep parking cash with the ECB next year”, Reuters)

Banks that won’t lend to other banks, businesses or consumers are a net-drag on the economy. Draghi’s long-term loans may prevent a financial system meltdown, but they won’t stop a credit crunch or a severe slump that could lead to a euro-wide depression. Turning off the credit tap while the public and private sector are deleveraging, is particularly destructive and is certain to deepen the crisis. Here’s an excerpt from the latest Organisation for Economic Co-operation and Development (OECD) report:

“The recovery in the OECD area has now slowed to a crawl… Emerging market output growth has also continued to soften, reflecting the impact of past domestic monetary policy tightening, sluggish external demand and high inflation. Against this background, the protracted fiscal-policy discussions in the United States and the deepening euro area crisis have highlighted the role of destabilising events and policies as well as the reduced political and economic scope for macroeconomic policies to cushion economies against further adverse shocks…

Decisive policies must be urgently put in place to stop the euro area sovereign debt crisis from spreading and to put weakening global activity back on track….The euro area crisis remains the key risk to the world economy…Prospects only improve if decisive action is taken quickly,” said OECD Chief Economist Pier Carlo Padoan.” (OECD “Economic Outlook” 2011)

Harsher penalties for budget sinners will not spur growth nor will stricter rules eliminate the massive account imbalances that are at the heart of the crisis. EU leaders need to revise their analysis and their remedies. Fiscal union can only be achieved through greater political-fiscal union, and that means debt mutualization (eurobonds). Absent the federal institutions and debt markets that imply authentic statehood, the crisis will continue to grow until the monetary union eventually fragments.

The antidote for recession is well known. When consumers are forced to cut their spending and businesses reduce investment, the government must increase its deficits to rev up spending and keep the economy going. Unfortunately, in Europe, hairshirts and thin gruel are all the rage, which is why conventional remedies, like fiscal stimulus, have been ruled out altogether. That said, the debt crisis is bound to reach a climax in 2012 as political gridlock and contractionary fiscal policies force one or more members of the EZ to withdraw from the union, thus paving the way for a larger breakup.